NEW YORK (CNN/Money) -
Do you think that real estate funds are a good investment for someone 65 years of age?
-- Janice Dodge, Claremont, Calif.
Sure, I think real estate funds can be a fine investment for a 65-year-old. As they can be for someone who's 25 years old, or 35 or 45 or, for that matter, 95.
The key isn't so much your age, but that the real estate funds complement an otherwise diversified portfolio of stocks, bonds and cash that makes sense given your particular situation.
In other words, just because real estate has become as popular in investing circles as Harry Potter has become to the kids-book crowd, you shouldn't be pigging out on real estate funds to the exclusion of other investments. After all, you don't have to be a wizard to realize that overloading on real estate today makes about as much sense as overloading on tech funds did during their heyday in the late '90s.
They're a good thing
That said, let me quickly run through the reasons why I think real estate funds can be a good addition to the portfolios of most "Muggles."
The first reason is that, historically, real estate securities have offered competitive long-term returns. Over the 10 years through mid-June, equity real estate investment trusts (REITs) -- a type of real estate security that can own properties ranging from apartments to office buildings to shopping malls -- gained an annualized 10.2 percent, slightly better than the Standard & Poor's 500 index's 9.9 percent over the same period.
I bring up this stat not because I want to suggest that REITs will always outperform the broad market (they won't), but because they can provide long-term capital growth, which is something that even 65-year-olds need if they're depending on their portfolio to generate income during retirement.
Speaking of income, REITs and other real estate securities also do a good job of throwing off income in the form of dividends. Currently, equity REITs are yielding about 6.4 percent, which is about three times as high as much as the current yield of the S&P 500.
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One word of caution, though: although most dividends will now be taxed as capital gains and thus at rates no higher than 15 percent as a result of the 2003 tax bill, REIT dividends will generally still be taxed as ordinary income at rates as high as 35 percent.
The reason is that, unlike other corporations, REITs generally do not pay corporate tax, so a tax break is already effectively built into the dividend. As with most tax matters, however, there are all sorts of little exceptions and complications.
For example, some funds may invest not only in REITs, but in real estate operating companies, whose dividends would likely qualify for the new low tax rate. So if you're investing in mutual funds that invest in REITs and other securities, I recommend you talk to the fund rep about what portion, if any, of the dividends the fund pays are likely to qualify for the lower tax rates under the 2003 bill.
Plus: Diversification benefits
The third reason I like real estate securities in a portfolio is that they can be a good diversifier. Real estate stocks have a low correlation with other stocks, which is a fancy way of saying they don't always move in synch with the broad market.
For example, while the S&P 500 posted an annualized loss of 10.4 percent over the past three years, REITs have gained an annualized 14.7 percent. Of course, low correlation is a two-way street. When the broad stock market was booming back in 1998 and 1999, real estate funds lost money.
Still, because real estate stocks and the regular stock market don't always zig and zag together, adding some real estate securities to a portfolio can lower the volatility of your overall portfolio, allowing you to achieve a given level of gains with less risk than you would take in a stock portfolio sans real estate. (For more on this diversification effect, click here.
So how much of your portfolio should you devote to real estate securities in order to take advantage of these benefits? There's no way that I know of to arrive at an "ideal" percentage. But I'd say that a range of 5 to 15 percent of the stock portion of one's portfolio would be appropriate for most investors.
You could arrive at that percentage by buying a combination of individual REITs, home builders, developers and real estate operating companies. But if you're not prepared to put in the time and effort to research the companies, I'd say you're better off buying one or two funds that own REITs and other real estate securities. You can search for such funds by going to our Fund Screener, which, by the way, is open to investors of all ages.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."
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